UNDERSTANDING THE,CASH FLOW STATEMENT
LOS 34.e: Demonstrate how the cash flow statement is linked to the
The cash flow statement reconciles the beginning and ending balances of cash over an accounting period. The change in cash is a resul t of the firm's operating, investing, and financing activities as follows:
Operating cash flow + Investing cash flow + Financing cash flow
Change in cash balance Beginning cash balance Ending cash balance
It is important to understand that net income, based on accrual accounting, is not the same thing as cash earnings. When the timing of revenue or expense recognition differs from the receipt or payment of cash, ir is reflecred in changes in balance sheet accounts.
For example, when revenues (sales) exceed cash collections, accounts receivable increase. The opposire occurs when cash collections exceed revenues; accounts . receivable (an asset) decrease. When purchases from suppliers exceed cash payments,
accounts payable (a liabiliry) increase. When cash payments exceed purchases, payables decrease.
Invesring activities typically relare to the firm's noncurrent assers, while financing activities typically relate to rhe firm's noncurrent liabilities and equiry.
Each balance sheet account can be analyzed in terms of the transactions thar increase or decrease the account over a period of rime. For example, the following is a
reconciliation of inventorv:
Beginning inventory balance + Invenrory purchases
Cost of goods sold Ending invenrory balance
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Study Session 8
Cross-Reference to CFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement
o ProFssor's Note: Gillen three oftlufour tJariab/es in the abolle reconciliation, it is eas)' to sollie for the fourth. This type ofana/)Isis can be applied to a17)' balance sheet account as long as you know which transactionJ increase" and which trallsactionJ decrease the account.
The firm's balance sheet, income statement, and cash flow statement are all related.
Understanding these relationships is important for analytical purposes, as well as for detecting possible aggressive accounting practices.
LOS 34.f: Demonstrate the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed USlllg income statement and balance sheet data.
Professor's Note: Throughout the discussion of the direct and indi7"CCt methods, remember the following points:
o •
CFO is calculated differently, but the result is the same under both methods.
The calculation of CFI and CFF is identical under both methods.
There is an inverse relationship between changes in assets and changes in cash flows. In other words, an increase in an asset account is a use of cash, and a decrease in an asset account is a source of cash.
There is a direct relationship between changes in liabilities and changes in cash flow. In other words, an increase in a liability' account is a source of cash, and a decrease in a liability is a use ofcash.
Sources of cash are positive numbers (cash inflows) and uses ofcash are negative numbers (cash outflows).
Direct Method
The direct method presents operating cash flow by taking each item from the income statement and converting itIO its cash equivalent by adding or subtraCting the changes in the associated balance sheet accounts. FootnOtes are often helpful in learning how inflows and OUtflows have affected the balance sheet accounts. The following are common examples of operating cash flow components:
• Cash collected from customers is typically the main component of CFO. Cash collections are calculated by adjusting sales revenues for changes in accounts receivable and changes in unearned (deferred) re\renue.
• Cash used in the production of goods and services (cash inputs) is calculated by adjusting cost of goods sold (COGS) for any change in inventory and any change in accounts payable.
• Cash operating expenses are calculated by adjusting selling, general, and
administrative (SG&A) expenses for the changes in any related accrued liabilities and/or prepaid expenses.
• Cash paid for interest is calculated by adjusting interest expense for any change in interest payable.
• Cash paid for taxes is calculated by adjusting income tax expense for any change in taxes payable and/ or deferred taxes.
Page 112 ©2008 Sch weser
Study Session 8 Cross-Reference to CFA Institute Assigned Reading #34 - Understanding the Cash Flow Statement Professor's Note: A common "trick" in direct method questions is to provide
information on depreciation expense aLong with other operating cash flow components. When using the direct method, ignore depreciation expense-it's a noncash charge. We'LL see Later that we do consider depreciation expense in indirect method computations, but we do this soLeLy because depreciation expense and other noncash expenses have been subtracted in caLcuLating net income (our starting point) and need to be added back to get cash flow.
Investing cash flows (CFI) are calculated by examining the change in the gross asset accounts that result from investing activities, such as property, plant, and equipment, intangible assets, and investment securities. Related accumulated depreciation or amortization accounts are ignored since they do not represent cash expenses.
~ Professor's Note: In this context, 'g~oss"simpLy means an amount that is presented
~ on the baLance sheet before deductmg any accumuLated depreClatlon or . amortization.
When calculating cash paid for a new asset, it is necessaryto determine whether old assets were sold. If assets were sold during the period, you must use the following formula:
cash paid for new asset =ending gross assets +gross cost of old assets sold - beginning gross assets
Professor's Note: It may be easier to think in terms ofthe account reconciliation
~.... format dl.ãscussed earlier. That is, beginning gross assets + cash paid for new assets
~ - gross cost ofassets soLd=ending gross aJSets. Given three ofthe variabLes, simpLy soLve for the fourth.
When calculating the cash flow from an asset that has been sold, it is necessaryto consider any gain or loss from the sale using the following formula:
cash from asset sold =book value of the asset+gain (or - loss) on sale
Financing cash flows (CFF) are determined by measuring the cash flows occurring between the firm and its suppliers of capital. Cash flows between the firm and its creditors result from new borrowings (positive CFF) and debt principal repayments (negative CFF). Note that interest paid is technically a cash flow to creditors, but it is included in CFO under U.S. GAAP. Cash flows between the firm and its shareholders occur when equityis issued, shares are repurchJsed, or dividends are paid. CFF is the sum of these twO measures:
net cash flows from creditors =new borrowings - principal Jmoullts repaid net cash flows from shareholders =new equity issued - share repurchases - cash dividends paidã
Cash dividends paid can be calculated from dividends declared and any changes in dividends p a y a b l e . '
©2008Schw~s~r Page 113
Stud" Session S
CrosscReference to CFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement
Finally, rotal cash flow is equal to the sum of CFO, eFl, and CFF. If calculated correctly, the total cash flow will equal the change in cash from one balance sheetto the next.
- .;. -", ',:: ":,". ; ' ,_"",~_~:~Pf" /,,:.;\,:~.>\,',t -"~'.'-. ;"', ã..~~~'::.?'~''''~':~:~~"'fãã.' ,.,ã"t~;:~c:':.~;'s:~,~.I';'~''\-. ':;':-: ,. :.. , .. ", _-'-" -
Example::®irectmethodfOf!CpmputingCFO
",",:;'
Prepare.a.cashflb~statemen.,t.u.~ingthe direct method for acompanywith~'e f()llo~~n~}ncorrie~t~tememƠri.db~lanceãsheets. ••...•< ....
Income Statement for lOX7 Sales
Expenses
Cost of goods sold Wages
Depreciation Interest T oral expenses
Income from continuing operations Gain from sale of land
Pretax income Provision for taxes Net income
Common dividends declared Balance Sheets for 20X7 and 20X6 Assets
Current assets Cash
Accounts receivable Invenrory
Noncurrenr assets Land
Gross planr and equipment less: Accumulated depreciation Net plant and equipmenr Goodwill
Total assets Liabilities Current liabilities
Accounts payable Wages payable Interest payable Taxes payable
S100,000
$52,500" .
"'S47S00 10;000 .
.57,56d~
20,000
. . "
$}7,500ãã
20X7
$33,000 '10;000 5.,000.
$35~{)OO
.U'~'~5!PO'o•.••.
<"(1"t;OOO)'.
$69,000 10,000
$162,000
$9,000 4,500 3,500 5,000
20X6
$9,000 9,000 7,000
$40,000 60,000 (9,000)
$51,000 10,000
$126,000
$5,000 8,000 3,000 4,000
Page 114 ©2008 Schweser
StuJy Session R Cross-Reference to CFA Institute Assigned Reading #34 - Understanding the Cash Flow Statement
Dividends payable Toral current liabilities Noncurrent liabilities
Bonds
Deferred tax liability T otalliabilities
6,000 1,000
28,000 21,000
$15,000 $10,000
20,000 15,000
$63,000 $46,000
Stockholders' eguiry Common srock Retained earnings Toeal equity
Toeal liabilieies& srockholders' equity
~f~,~>$40,oqq [:(0 59,000
">if'$T62,000
$50,000 30,000
$80,000
$126,000
KeeJ:rtr:a.ck:ot the: b<lail.rrce sh<:etirelmsus<:dto calculareCPO by ma:rki.ng u" again when determining
cash collections=sales ....,i.ncrease in accounts receivable=$100,000.,.. $1,000 =
$99,000
begillningreceiva.hle~+sales~.. cash collections=ending receivables =
$9,000+ $100,.000.;"'$99,000= $10, 000
©200SS.:hw.:s.:r Pag.: 115
Srud)' Session 8
Cross-Reference' to CFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement
cash paid to suppliers =- COGS + decrease in inventory+ increase in accounts payable = -$40,000 + $2,000 + $4,000 = -$34,000
."
beginning inventory +purchases - COGS =ending inventory =
$7,000 + $38;000 (not provided) - $40,000 = $5,000
beginning accounts payable +purchases - cash paid to suppliers =ending accounts payable: $5,000 + $38,000 (not provided) - $34,000 = $9,000 cash wages = - wages - decrease in wages payable = -$5,000 - $3,500 =-$8,500
beginning wages payable +wages expense - wages paid = ending wages payable =
$8,000 + $5,000 - $8,500 =$4,500
cash interest=~interest expense + increase in interest payable: -'-$500 + $500= 0 beginning interest payable +interest expense - interest paid =endingimerest payable =$3,000 + $500 - $0 = $3,500 .
ããbeginning taxes payable+beginning deferred tax liability+tax expense - paid: end.ing taxes payable+ending deferred tax liability=$4,000+$1
$20,000 - $14,000 : $5,000+ $20,000
cash taxes= __tax expense+increase in taxes payable+increase in deferredtax
. liability .
Cash coliecrions
Cashtosuppliers Cash wages Cash interest Cash taxes
$99,000 C\4,OOO)
(8,500)
o
(14,00'0)
Cash flowfromoperations 542,)00
Page 116 ©2008 Schweser
Study Session 8 Cross-Reference to CFA Institute Assigned Reading #34 - Understanding the Cash Flow Statement
Investing cash flow:'
In this example, we 'have two components of investing cash flow: the sale of land and me change in gross plant and equiPment (P&E).
cash from sale o/land = decrease in asset +gain on sale = $5,000 +$10,000 =
$15,000 (source)
beginningJand+l~nd.purchased..- gross cost ofland. sold = ending '..' $40,000+$0-$,5,000='$35,000
P&Epurchased= endinggrossp&E+gross cost of P&E sold __be~~inlninlg
= $85,000+ $0-$60,000 = $25,000 (use)
::'~..\\-~';.
if\\;.tpegi1irii~g.igr6s$P&:E+.P&E purchased -' gross cost orp&:E j.':;',}jti:t;,$,;6;j9:20Q.+.$25 ;°°81 $ °;"$85,000..
Cash from sale of land
Purchase of plant and equipmenr Cash flow from investmenrs
$15,000 (25,000) (SI0.000) Financing cash flow:
~tlShfrombondissue=endinghonds payable+bonds repaid - beginning vv,..""":';...•';.,ã•••':
payable = $15,000 " $0 - $10,000 = $5,000 (source)
beginning bonds payable +bonds issued - bonds repaid =endingbo!nd~)p:aY~lblt:ãi
= $10,000+ $5,000- $0 = $15,000
cash to reacquire stock=beginning common stock+stock issued - ending common stock = $50,000 +$0- $40,000= $10,000 (use, or a net share repurchase of
$10,000)
beginning common stock +stock issued - stock reacquired = ending common stock = $50,000+$0 - $10,000 = $40,000
,cash dividends= - dividend declared +increasein dividends payable
= -$8,500* +$5,000 = -$3,500 (use)
beginning dividends payable + dividends declared - dividends paid= en.di~i'
. dividends payable = $1,000 +$8,500 - $3,500= $6,000
i'..' "
'"Norc: If the dividend' declared amount is not provided, you can ca.lculate the; •.•.•...
amount as follows: dividends declared= beginning retained earnings+net'incofue,j;
ending retained earnings. Here, $30,000 +$37.500 - $59,000 = $8,500.
©2008 Schweser Page 117
Srud\' Session 8
Cross- Reference to CFA Institu te Assigned Reading #34 - Understanding the Cash Flow Statement
Sale of bonds Repurchase of srock Cash di\ridends
Cash flow from financing Total cash flow:
Cash flow from operations Cash flow from investments Cash flow from financing Total cash flow
Indirect Method
,,"':'" , :
ããã:$5ãoooiã,i,
~:-'-'.~""" .,'): ,:::::~~>::;~
...•..ãã•• XlQ~OOO):':;,
ãããã~:;.(~SOO),;~
($8500)i;':
$~~~560?i'~\
ããã(1,9;000)'3'>
,.ãã>,ã't8;56o,~ã\\ã
The three components of cash flow under the indirect method are equalto the three components of cash flow as under the direct method. The only difference in
presentation is that cash flow from operations is calculated in a different manner.
Using the indirect method, operating cash flow is calculated in four steps:
Step 1:
Step 2:
Step 3:
Step 4:
Begin with nee income.
Subtracc gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land).
Add back aU noncash charges ro income (such as depreciation and amortization) and subtract all noncash components of revenue.
Add or subtract changes to balance sheet operating accounts as follows:
• Increases in the operating asset accQunts (uses of cash) are subtracted, while decreases (sources of cash) are added.
• Increases in the operating liability accounts (sources of cash) are added, while decreases (uses of cash) are subtracted.
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Cash flow from investing activities and cash flow from financing activities are
calculated the same way as under the direct method. As was true for the direct method, total cash flow is equal tothe sum of cash flow from operating activities, investing activities, and financing activities. If calculated correctly, the total cash flow will be equaJ to the change in the cash balance over the period.
©2008Schweser
Study Session 8 Cross-Reference to CFA Institute Assigned Reading#34 - Understanding the Cash Flow Statement Discrepancies between the changes in accounts reported on the balance sheet and those
reported in the statement of cash flows are typically due to business combinations and changes in exchange rates.
Exa.m.ple': liidIrectriiethodforcomputing CFO
Calculate cash flow from operations using the indirect method for the same company iathe previous. example.
rec:ei,'ablesã. and inventories and add increasesoL
\'-.
Net income
Gain from sale of land Depreciation
Subtotal
Changes in operating accounts Increase in receivables Decrease in invenrories Increase in accounrs payable Decrease in wages payable Increase in inrerest payable Increase in ta.xes payable Increase in deferred raxes Cash flow from operarions
$37,500 00,000)
7,600
$34,500
($1,000) 2,000 4,'000 (3,500) 500 1,000 5,000 S42,500